The procompetitive story that could undermine the DOJ’s e-books antitrust case against Apple

Did Apple conspire with e-book publishers to raise e-book prices? That’s what DOJ argues in a lawsuit filed yesterday. But does that violate the antitrust laws? Not necessarily—and even if it does, perhaps it shouldn’t.

Antitrust’s sole goal is maximizing consumer welfare. While that generally means antitrust regulators should focus on lower prices, the situation is more complicated when we’re talking about markets for new products, where technologies for distribution and consumption are evolving rapidly along with business models. In short, the so-called Agency pricing model Apple and publishers adopted may mean (and may not mean) higher e-book prices in the short run, but it also means more variability in pricing, and it might well have facilitated Apple’s entry into the market, increasing e-book retail competition and promoting innovation among e-book readers, while increasing funding for e-book content creators.

The procompetitive story goes something like the following. (As always with antitrust, the question isn’t so much which model is better, but that no one really knows what the right model is—least of all antitrust regulators—and that, the more unclear the consumer welfare effects of a practice are, as in rapidly evolving markets, the more we should err on the side of restraint).

Apple versus Amazon

Apple–decidedly a hardware company–entered the e-book market as a device maker eager to attract consumers to its expensive iPad tablets by offering appealing media content. In this it is the very opposite of Amazon, a general retailer that naturally moved into retailing digital content, and began selling hardware (Kindle readers) only as a way of getting consumers to embrace e-books.

The Kindle is essentially a one-trick pony (the latest Kindle notwithstanding), and its focus is on e-books. By contrast, Apple’s platform (the iPad and, to a lesser degree, the iPhone) is a multi-use platform, offering Internet browsing, word processing, music, apps, and other products, of which books probably accounted–and still account–for a relatively small percentage of revenue. Importantly, unlike Amazon, Apple has many options for promoting adoption of its platform—not least, the “sex appeal” of its famously glam products. Without denigrating Amazon’s offerings, Amazon, by contrast, competes largely on the basis of its content, and its devices sell only as long as the content is attractive and attractively priced.

In essence, Apple’s iPad is a platform; Amazon’s Kindle is a book merchant wrapped up in a cool device.

What this means is that Apple, unlike Amazon, is far less interested in controlling content prices for books and other content; it hardly needs to control that lever to effectively market its platform, and it can easily rely on content providers’ self interest to ensure that enough content flows through its devices.

In other words, Apple is content to act as a typical platform would, acting as a conduit for others’ content, which the content owner controls. Amazon surely has “platform” status in its sights, but reliant as it is on e-books, and nascent as that market is, it is not quite ready to act like a “pure” platform. (For more on this, see my blog post from 2010).

The Agency Model

As it happens, publishers seem to prefer the Agency Model, as well, preferring to keep control over their content in this medium rather than selling it (as in the brick-and-mortar model) to a retailer like Amazon to price, market, promote and re-sell at will. For the publishers, the Agency Model is essentially a form of resale price maintenance — ensuring that retailers who sell their products do not inefficiently discount prices. (For a clear exposition of the procompetitive merits of RPM, see this article by Benjamin Klein).

(As a side note, I suspect that they may well be wrong to feel this way. The inclination seems to stem from a fear of e-books’ threat to their traditional business model — a fear of technological evolution that can have catastrophic consequences (cf. Kodak, about which I wrote a few weeks ago). But then content providers moving into digital media have been consistently woeful at understanding digital markets).

So the publishers strike a deal with Apple that gives the publishers control over pricing and Apple a cut (30%) of the profits. Contrary to the DOJ’s claim in its complaint, this model happens to look exactly like Apple’s arrangement for apps and music, as well, right down to the same percentage Apple takes from sales. This makes things easier for Apple, gives publishers more control over pricing, and offers Apple content and a good return sufficient to induce it to market and sell its platform.

It is worth noting here that there is no reason to think that the wholesale model wouldn’t also have generated enough content and enough return for Apple, so I don’t think the ultimate motivation here for Apple was higher prices (which could well have actually led to lower total return given fewer sales), but rather that it wasn’t interested in paying for control. So in exchange for a (possibly) larger slice of the pie, as well as consistency with its existing content provider back-end and the avoidance of having to monitor and make pricing decisions, Apple happily relinquished decision-making over pricing and other aspects of sales.

The Most Favored Nation Clauses

Having given up this price control, Apple has one remaining problem: no guarantee of being able to offer attractive content at an attractive price if it is forced to try to sell e-books at a high price while its competitors can undercut it. And so, as is common in this sort of distribution agreement, Apple obtains “Most Favored Nation” (MFN) clauses from publishers to ensure that if they are permitting other platforms to sell their books at a lower price, Apple will at least be able to do so, as well. The contracts at issue in the case specify maximum resale prices for content and ensure Apple that if a publisher permits, say, Amazon to sell the same content at a lower price, it will likewise offer the content via Apple’s iBooks store for the same price.

The DOJ is fighting a war against MFNs, which is a story for another day, and it seems clear from the terms of the settlement with the three setting publishers that indeed MFNs are a big part of the target here. But there is nothing inherently problematic about MFNs, and there is plenty of scholarship explaining why they are beneficial. Here, and important among these, they facilitate entry by offering some protection for an entrant’s up-front investment in challenging an incumbent, and prevent subsequent entrants from undercutting this price. In this sense MFNs are essentially an important way of inducing retailers like Apple to sign on to an RPM (no control) model by offering some protection against publishers striking a deal with a competitor that leaves Apple forced to price its e-books out of the market.

There is nothing, that I know of, in the MFNs or elsewhere in the agreements that requires the publishers to impose higher resale prices elsewhere, or prevents the publishers from selling throughApple at a lower price, if necessary. That said, it may well have been everyone’s hope that, as the DOJ alleges, the MFNs would operate like price floors instead of price ceilings, ensuring higher prices for publishers. But hoping for higher prices is not an antitrust offense, and, as I’ve discussed, it’s not even clear that, viewed more broadly in terms of the evolution of the e-book and e-reader markets, higher prices in the short run would be bad for consumers.

The Legal Standard

To the extent that book publishers don’t necessarily know what’s really in their best interest, the DOJ is even more constrained in judging the benefits (or costs) for consumers at large from this scheme. As I’ve suggested, there is a pretty clear procompetitive story here, and a court may indeed agree that this should not be judged under a per se liability standard (as would apply in the case of naked price-fixing).

Most important, here there is no allegation that the publishers and Apple (or the publishers among themselves) agreed on price. Rather, the allegation is that they agreed to adopt a particular business model (one that, I would point out, probably resulted in greater variation in price, rather than less, compared to Amazon’s traditional $9.99-for-all pricing scheme). If the DOJ can convince a court that this nevertheless amounts to a naked price-fixing agreement among publishers, with Apple operating as the hub, then they are probably sunk. But while antitrust law is suspicious of collective action among rivals in coordinating on prices, this change in business model does not alone coordinate on prices. Each individual publisher can set its own price, and it’s not clear that the DOJ’s evidence points to any agreement with respect to actual pricing level.

It does seem pretty clear that there is coordination here on the shift in business models. But sometimes antitrust law condones such collective action to take account of various efficiencies (think standard setting or joint ventures or collective rights groups like BMI). Here, there is a more than plausible case that coordinated action to move to a plausibly-more-efficient business model was necessary and pro-competitive. If Apple can convince a court of that, then the DOJ has a rule of reason case on its hands and is facing a very uphill battle.